SatyajitDas

Negative interest rates, which central banks in several countries have implemented as a way to spur economic growth, is a radical move. In this three-part series, ‘Negative Thinking,’ commentator Satyajit Das examines this policy and the risk it carries.

Several of the world’s central banks have crossed the Rubicon, commencing a high-risk experiment with negative interest rates. The intent is clear: reduce debt by confiscation and transfer wealth from savers to borrowers. This is ultimately an admission of defeat, as traditional means of bringing excessive debt under control have failed.

Negative rates are now the policy of the European Central Bank, with a deposit rate of minus 0.40%. Ditto for Switzerland, where the rate is minus 0.75%. In Sweden, the rate is minus 0.35%. The Bank of Japan too has announced negative interest rates, of 0.10%.

More than $26 trillion of government bonds now trade at yields of below 1%, with around $7 trillion currently yielding less than 0%. Government bonds in Germany with a maturity of seven years are trading at negative yields, while Swiss and Japanese government bonds out to 10 years trade at negative yields.

Negative yields mean that if an investor places a deposit with a bank, at maturity the investor receives an amount less than the original investment. In effect, the depositor pays to place money with the bank. In the case of bonds, negative yields mean that investors accept an economic loss, as the price paid by the investor is greater than the present value of the interest payments and principal repayment for a security.

Negative real rates entail return on the amount invested but loss of purchasing power because inflation rates are greater than the return. Negative nominal rates involve a guaranteed loss of capital invested.

The lack of impact on the real economy reflects the failure of these policies to materially increase consumption and investment. Heavily indebted or increasingly cautious households are reluctant to borrow to fund spending. Low business investment reflects lack of demand, over-capacity, and a reluctance to increase debt in a potentially deflationary environment.

Negative rates also may create deflationary pressures. Artificial reduction in the cost of capital may encourage investment in excess capacity, which in turn drives down prices for goods and services. Lower cost of capital may encourage substitution of labor with capital goods, which curtails both hiring and demand, which in turn adversely affects growth and inflation.

Moreover, reducing excess reserves, where they exist, has proved difficult because of the lack of demand for new credit. In part, this reflects the fact that most banks have not passed the negative rates on to the majority of customers. In jurisdictions with negative official rates, some banks only charge large corporations or fund managers to deposit cash. Most banks do not yet charge retail customers to deposit money. There are limited examples of banks paying customers to borrow. Banks dependent on deposits are reluctant to reduce rates, fearing the loss of their funding base.

Lending rates have not come down in line with official rates. Concerns about profitability, compounded by new higher capital and liquidity regulations, have reduced banks’ willingness to lend.

Most economies with negative rates are caught in a credit trap. Credit demand is weak and credit supply is constrained. Policy measures such as negative rate and additional QE are increasingly ineffective.

Negative interest rates are also impotent in managing exchange rates. The latest round of rate cuts have not affected currency values as expected. Both the yen
USDJPY, +0.01%
and the euro
EURUSD, +0.0088%
appreciated against the U.S. dollar
DXY, +0.43%
after the Bank of Japan and the European Central Bank announced negative rates. Persistence with this policy risks triggering a race to the bottom for both interest rates and currencies.

Negative rates come with other complications. Negative rates change the role of default or bankruptcy in debt markets. A borrower could default only on principal repayments, since there is no interest payment. Covenants such as interest or debt cover designed to provide early warning of distress would have less significance or none at all. Depending on bankruptcy laws, borrowers may lose and lenders gain in cases of default.

Negative or ultra-low interest rates also reduce the risk of default. As shown in Japan, it creates zombie companies and industries by distorting the cost of capital and finance encouraging malinvestment. Such companies do not make necessary adjustments to strategy or business practices. Unproductive investments are not restructured or sold. Banks do not write off bad loans, relying instead on low- or negative rates to allow these zombie companies to continue operations. Weakened profitability from negative interest rates discourages banks from aggressively realizing bad debts.

In effect, negative rates delay essential restructuring to remove the detritus of previous crises. It restricts the supply of credit to the wider economy, affecting economic activity. Misallocation of capital deepens the malaise, and an ultimate resolution to this global problem becomes even more costly and difficult.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.